Robert Peston gave a superb free public lecture on Thursday evening. He is a peerless public speaker and summed up the global financial crisis with crystal clarity. Part of his theme was that, once the 2008 crash had occurred, we were left with no alternative to our current predicament. To be honest I wholeheartedly disagree with that. I think we are where we are because extraordinary measures are being taken to get us into this pickle.
Robert Peston described how, over the past 200 years until 1980, credit growth in the UK had kept pace with economic growth. After 1980 however, credit expansion soared* whilst economic growth increased modestly -following the previous trend line. Debt owed between UK financial institutions ballooned to ten trillion pounds –as much as the gross assets of UK households. In 2008 that disparity came to a crunch when it became clear that the expanded stock of debt did not have a correspondingly expanded revenue stream to service it. Debt is only worth as much as the debtor is able to repay. The crashing revaluations in 2008 were because it belatedly became apparent that debtors were only going to be repaying according to the level of the economy. The face value of the debt was a fiction that came about because lenders had (indirectly) simply been lending more to service the existing debt burden.
Robert Peston said that journalists (including him) let us all down by failing to forewarn us all of the danger of unsustainable credit expansion. He said that in hindsight we should never have inflated the credit bubble. That is very noble of him but I wonder whether we have also been very foolish in how we have reacted AFTER creating the bubble. Have we thwarted an absolutely vital part of our economic system? Capitalism has a tendency to fail to distribute financial surplus back to debtors. Economic growth traditionally occurs in fits and starts, as credit fuels expansion, until a crash and default reboots the system; then, after much tragic waste, capitalism rises phoenix-like to repeat the process. Unless unsustainable debt gets sloughed off with such defaults, the debt strangles the economy like an outgrown shell for a crab. As money gets diverted away from consumption and investment towards instead paying down debt, the economy contracts and that further reduces the ability to service the debt.
The government response to the 2008 crisis was to backstop the debt and to prevent it from being written down as it needed to be. That was not a pre-existing obligation of the government. Potentially, the insured deposits in the banking system could have been backed fully by the government (so ensuring uninterrupted function of the payment system) whilst bond holders for the ten trillion pounds of debt between UK financial institutions could have been left to resolve defaults in a purely commercial, private sector, manner. Presumably holders of bank bonds would have taken debt to equity conversion such that they would have become the new owners of a smaller less leveraged financial system. Robert Preston stated that that approach was avoided partly because it was feared that insurance companies would then have become insolvent since they too were major holders of financial sector bonds.
The financial regulators are charged with the job of ensuring that things never get to the point where bail outs are needed. Clearly they flunked that obligation. Radical (but simple) regulations could in principle vastly reduce financial fragility (see post). But if regulators do mess up and banks or insurance companies fail, I think we need a radically different mind-set about what sort of bail outs get done. Currently the approach is to bail out the core of the problem although the bail-out is justified on the basis of how the core problem connects to the wider economy. Obviously it would be stupid to blunder into a scenario where say hurricane damage was left unrepaired, whilst building workers were left unemployed, simply because a banking crisis had wiped out the insurance companies, leaving everyone’s insurance claims unpaid. To my mind however the appropriate government response should be to step in and directly pay those insurance claims and NOT to bail out the bank bond holders, way upstream in the chain of causality. Clearly the whole scenario is the result of a gross lapse of government financial regulation so it seems fine to me that the government steps in to pay such insurance claims. In a civilised country we should expect that when we insure our house (or even insure a ship against shipwreck), financial regulation should have ensured that any offered insurance can be honoured.
My whole line of argument may seem contradictory. On the one hand I’m saying that bank bond holders should not be protected from the realities of capitalism and on the other hand I’m saying that people should be able to blithely rely on insurance companies being able to pay out. My point is that there should be a very select few crucial financial services that are extremely conservatively regulated and have an absolute government back stop. The payment system and insurance against real events (eg insurance of buildings, vehicles, ships etc.) fall into that category. Critically the government backstop needs to not be for the provider companies but rather of the claims from the customers. So a failing insurance company would still fail but the government would write the cheques to pay the insurance claims of customers when that happened.
We need the rest of the financial system to be the zone where losses are absorbed. Finance is all about competing attempts to strive for exponential growth (1) . Obviously it is impossible not to have plenty of losses in any such system. A line has to be drawn between on the one hand insuring against shipwreck and on the other hand credit default swaps or derivatives for hedging interest rates or currency exchange rates etc. It needs to be made absolutely explicit that narrow “Main-street” insurance is government backed whilst financial derivatives are at the mercy of counterparty risk and are in an utterly separate system prone to failure.
Another justification sometimes given for the 2009 bailouts was that pensions relied on stock market prices. If there is concern that people relying on private pensions will suffer from a financial crash and government intervention is deemed appropriate to help them; then that would best be done by paying the pensioners directly by increasing the universal state pension paid to every pensioner. It is important to remember that low stock market prices would mean those saving for future pensions would be expected to get higher returns. So any such bailout of pensioners could be offset by taxes on those saving. Conversely current interventions to inflate stock prices hinder future pensions.
In 2009, Gordon Brown and Timmy Geithner were hailed as heroes for “saving the banks”. What exactly did they save? My fear is that all Gordon Brown did was to convert a near instantaneous necessary contraction of the banking system into an agonisingly slow, multi-decade contraction. What we “gain” is the maintenance of tens of thousands of elite banking jobs for the interim. Because the big UK banks RBS and HBOS were taken into state ownership, those jobs in effect are extraordinarily highly paid government jobs. My fear is that the political establishment was so proud of having facilitated the “wealth creation” of banking expansion, that vanity clouded their judgement when it came to letting that “wealth”get written down. Stephen Hester has described the current role of the investment banking division of RBS as, “…to diffuse the largest balance sheet risk time bomb ever assembled in history”. That “time bomb” was assembled in the first place by the very same people now “diffusing” it. It is an utterly pointless exercise. The ledger could just be wiped and those people could be left to get on with something else. We might as well be employing those people to walk around behind Gordon Brown, in procession, applauding. The elite investment bankers are recruited from the worlds brightest and best. They are sort after (and needed) for alternative jobs. A tragic irony is that many would rather be doing something else.
In his lecture, Robert Peston described how, as the financial sector pays down the debts it owes itself, government debt takes its place. If debts are not written down, that is all that can happen. The banks gather money from the economy and use it to pay down their own debts. That money consequently disappears from the economy instead of circulating around being taxed. The consequent lack of tax revenue leaves government finances in deficit and that deficit replaces the intra-financial corporate debt with government debt. Unlike corporate debt, government debt has no way of defaulting. We are stuck with it unless we create a tax that can retire it. Maturation of government debt is simply a conversion to bank reserves which themselves are really a sort of government debt. I also think it is greatly mistaken to believe that a bloated stock of government debt has no malign effects (see post “Political consequences of risk free financial assets” and the section “A zero interest rate policy does not reduce the financial overhead” on page 18 of this pdf).
*The economic transition that took place in 1980 is explored in “Isn’t a financialized economy the goose that lays our golden eggs?” on page 10 of this pdf)
(1) see “Monetary expansion attempts to realise the miracle of compound interest” on page 17 of this pdf)
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